Venture-backed startups ask for audits because an investor, lender or acquirer requires one. The first audit lands on a company with a young accounting function, a cap table that has changed several times and preferred stock agreements that need a close read. Much of the risk sits in the equity section.
This guide covers the classification analysis, the surrounding accounting topics and the procedures that produce a defensible file.
Why preferred stock classification drives the balance sheet
A startup's convertible preferred stock can land in one of three places: liability, temporary equity or permanent equity. The answer changes total stockholders' equity, working capital in debt tests that include it, and what an investor sees when it reads the balance sheet.
Liability. ASC 480 requires liability classification for shares that are mandatorily redeemable, and for shares that carry an unconditional obligation to settle in a variable number of shares for a fixed monetary amount. Plain convertible preferred does neither, but terms must be read, not assumed.
Temporary equity. SEC staff guidance codified at ASC 480-10-S99-3A, which cites Accounting Series Release 268, requires an instrument to sit outside permanent equity if it is redeemable at a fixed or determinable price on a fixed or determinable date, at the option of the holder, or on the occurrence of an event not solely within the control of the issuer. The SEC's reasoning was that a security whose redemption is outside the issuer's control differs significantly from conventional equity capital, and the future cash obligation should be highlighted. The guidance is written for SEC registrants. A private company that applies it by analogy documents that policy choice.
Permanent equity. The default when no redemption feature of that kind exists.
Reading the charter for redemption features
The test turns on the certificate of incorporation, the investors' rights agreement and the stock purchase agreement. Look for:
- Holder put rights or redemption dates, which are redemptions at the option of the holder or on a fixed date.
- Deemed liquidation events. A merger, sale of substantially all assets or exclusive license can trigger a liquidation preference payable in cash to preferred holders. Whether that event is within the issuer's control depends on who votes. If preferred holders hold a blocking vote or the right to elect a board majority, or if the common holders could lose control in the transaction, the event is not solely within the issuer's control.
- Board control shifts. A call option normally within the issuer's control can fall outside it through the interaction of other terms, for example when a class of preferred shareholders can take control of the board on failure to pay required periodic dividends.
- Ordinary liquidation. Redemption features that arise only on a liquidation in which all assets are sold and proceeds are distributed pro rata to all equity holders do not preclude permanent equity.
- Contingent features. The SEC staff guidance does not weigh probability. If the entity could be required to provide cash to the holder on an event that is not solely within its control, the instrument is reported as temporary equity.
Classify each series of preferred stock as a unit, based on its terms.
Presentation
Redeemable preferred stock appears separately from permanent equity. SAB Topic 3.C summarizes the requirement: redeemable preferred stocks are not included in amounts reported as stockholders' equity, and their redemption amounts are shown on the face of the balance sheet. The balance sheet in a startup file therefore shows convertible preferred stock between liabilities and the stockholders' deficit, and the deficit looks severe even when the company is well funded. Explain it in the disclosures and to those charged with governance.
Convertible features and other terms
- Embedded conversion features. After ASU 2020-06, the beneficial conversion feature and cash conversion models are removed. The models that remain are bifurcation of an embedded conversion feature as a derivative under ASC 815 and the substantial premium model. For entities other than SEC filers that are public business entities and not smaller reporting companies, the amendments are effective for fiscal years beginning after December 15, 2023.
- Other embedded features. Anti-dilution provisions, participation rights and mandatory conversion on an IPO below a stated price each need separate analysis.
- Warrants and side letters. Freestanding warrants issued with preferred stock are assessed under ASC 480 and ASC 815-40, and measured at fair value if liability-classified.
- Tranche rights. An obligation to sell a second closing of preferred stock at a fixed price can itself be a freestanding instrument.
Other audit areas for a venture-backed company
- Cap table and equity rollforward. Tie shares issued and outstanding by class to the stock ledger, transfer agent or cap table platform, board approvals and the charter. See the statement of stockholders' equity rollforward guide.
- Stock compensation. Test grant dates, fair value of common stock and expense. The 409A valuation is evidence of fair value for options, and the ASC 718 guide covers the accounting.
- Convertible notes and SAFEs. Review the instruments outstanding at year end and those that converted into the preferred round.
- Revenue recognition. Evaluate each stream under ASC 606; early pricing and contracts are new.
- Going concern. Burn rate, runway and plans are central. See going concern assessment.
- Related parties. Founders, investors and directors transact with the company; see related party transactions.
Worked example (illustrative numbers)
A startup closes a Series A on January 15 of its first fiscal year: 2,000,000 shares of Series A convertible preferred at $5.00 per share, gross proceeds $10,000,000, with $400,000 of issuance costs. The terms give holders a 1x liquidation preference on a deemed liquidation event, including a merger, and the investors elect a majority of the board.
- The deemed liquidation event is outside the company's control because the preferred holders control the vote.
- Series A is classified in temporary equity.
- Initial carrying amount: $10,000,000 less $400,000 issuance costs = $9,600,000.
- Permanent equity at year end includes common stock, additional paid-in capital and the accumulated deficit. If the accumulated deficit is $6,000,000 and paid-in capital is $1,200,000, stockholders' deficit is $4,800,000, even though the company holds the proceeds in cash.
The file should document the analysis term by term, the conclusion, the measurement policy for subsequent accretion if redemption becomes probable, and the disclosures.
Audit procedures
- Read the charter, financing agreements and amendments for each series; build a classification memo.
- Evaluate redemption, deemed liquidation and board control terms against ASC 480-10-S99-3A.
- Evaluate freestanding and embedded features for bifurcation under ASC 815.
- Recompute the carrying amount, issuance costs and any accretion.
- Confirm shares outstanding with legal counsel, the transfer agent or the cap table administrator.
- Test equity transactions to board minutes and bank receipts.
- Evaluate the 409A valuation and option grants.
PBC items
- Amended and restated certificate of incorporation and all amendments
- Stock purchase agreements, investors' rights agreement, voting agreement and side letters
- Cap table reconciled to the stock ledger
- Board and stockholder minutes and consents
- Warrant, note and SAFE agreements
- 409A valuation reports and option grant listing
- Closing statements and bank evidence of proceeds
- Legal counsel response on equity matters
Red flags
- A cap table that does not tie to the charter's authorized shares
- Preferred stock classified in permanent equity with no written analysis
- Side letters granting redemption or protective rights absent from the main agreements
- Option grants priced below a recent preferred round without explanation
- Shares issued without board approval
Sources
- FASB ASC 480-10-S99-3A (SEC staff announcement on classification and measurement of redeemable securities, citing ASR 268), as quoted in Grant Thornton, Share-based payments: Navigating the guidance in ASC 718
- SEC, Staff Accounting Bulletin Topic 3: Senior Securities, Topic 3.C on redeemable preferred stock
- FASB, ASU 2020-06, Debt with Conversion and Other Options and Derivatives and Hedging, full text on PwC Viewpoint
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